Are You Getting Paid for the Risk?

There is a line that every junior trader on Wall Street learns early: “In the markets, bulls can make money, bears can make money, but pigs just get slaughtered.”

The idea being that bullishness, or bearishness, can pay off if well reasoned, but investors who are blind with greed -- and take ever-higher risks in search of ever-higher returns -- are likely to land in the rendering machine.

Yet it has been a tricky business deciding who has been taking “excessive” risks in world markets recently.

In the quarter ended Friday, investors continued to bid up the things that have done very well over the last few years, such as U.S. small-company stocks and commodities like silver and copper.

Shares in emerging markets including Brazil, India and Russia also continued to soar, even as some Wall Street pros warned that those rallies, in particular, were overdone.

Among the worst bets, meanwhile, were the government bonds of the U.S., Japan and Germany -- securities that, all other things being equal, are considered low-risk investments.

As the Federal Reserve, the European Central Bank and the Bank of Japan all tightened credit in the first quarter (in Japan’s case, officials took a very tentative first step in that direction), the prices of U.S., Japanese and German bonds slumped, driving their yields up sharply.

Shares of the Vanguard Long-Term Treasury bond mutual fund sank 5.1% in the quarter. By contrast, the share price of the Fidelity New Markets Income fund, which owns bonds of emerging-market countries, rose 1.6% in the period.

A long list of veteran investors have decried what they’ve viewed as inordinate risk-taking in financial markets in recent years. That risk-taking, they say, is evident in the narrowing of the “spread” between U.S. government bond yields and yields on securities normally seen as much less secure than government issues.

Case in point: Four years ago, the average annualized yield on an index of 100 corporate junk bonds tracked by KDP Investment Advisors was about 10.5%, while the yield on the 10-year U.S. Treasury note was 5.4%. The spread therefore was more than 5 percentage points.

Now, that spread is a mere 2.7 points, with the junk bond index yield at about 7.6% and the 10-year Treasury at 4.85% as of Friday.

The argument against junk bonds, emerging market bonds, small-company stocks and other classically risky assets is that current prices can’t be justified given what could go wrong. These historically have been volatile sectors, prone to sudden and deep sell-offs.

Bill Gross, who manages the world’s biggest bond mutual fund at Pacific Investment Management Co. in Newport Beach, is among the market pros who don’t have the stomach for the level of risk other investors have been happy to take on in certain bond and stock sectors. They say they want prices of those assets to fall before they’ll consider buying.

“The crash of risk assets and their return to normalcy may be hard to time, but ... these periods never end well,” Gross wrote in his latest monthly client letter.

“If an investor is being paid too little to await his eventual demise, then it seems he should rethink the proposition,” he added.

Too little reward for the risk, though, seems to have applied as much to the developed world’s government bond markets over the last year as to more speculative markets.

For example, why were some investors willing to buy 10-year Treasury notes with a yield of 4.33% as recently as mid-January? At the time, the Fed’s benchmark short-term rate already was 4.25% and almost certainly was going higher (which it has, to 4.75% last week).

Those bond buyers probably would argue that they expected the economy to slow substantially soon, leading to falling interest rates and making a locked-in 4.33% rate look smart.

Likewise, some investors accepted a yield of just 1.2% on Japanese 10-year government bonds in June, apparently figuring there was little chance of a sustained recovery in that nation’s long-suffering economy.

But that recovery now seems quite real, enough so that the Bank of Japan said March 9 that its 5-year-old policy of holding short-term rates near zero was coming to a close. The 10-year Japanese government bond yield ended the quarter at 1.78%, its highest level since August 2004.

In the bond market, “have we been faked out? You bet,” said Andrew Brenner, head of global fixed-income investing for Hapoalim Securities in New York.

To look at it another way, aggressive betting on an economic slowdown has been a form of greed on the part of bearish investors for the last year, and they’ve been consistently wrong.

Now consider the investors who have been happy buyers of junk bonds, emerging market stocks and bonds, small-company stocks, commodities and other classically risky assets.

Those are the kinds of investments you want to own when the economy is expanding. Consciously or subconsciously, buyers of those assets have bet on global growth, and they’ve been right.

They’ve also been backed up by the world’s three major central banks, in the sense that the banks’ message in the first quarter was that the global economy was healthy enough to warrant -- and to handle -- higher interest rates.

Could classically risky assets be due for a pullback? Of course. They’ve had a great run.

The Russell 2,000 index of U.S. small-company stocks zoomed 13.6% in the first quarter, compared with a 3.7% gain for the blue-chip Standard & Poor’s 500 index.

The Brazilian stock market rocketed 13.4% in the quarter after rallying 28% last year. But it has shown signs of tiring in recent weeks, as have some other emerging markets. The main Brazilian share index hit an all-time high of 39,239 on March 3. On Friday it was at 37,952, or 3.3% below the record high.

Even if the rallies in riskier assets are overdone at the moment, however, we don’t know whether we’re near the end of the line for these bull markets or just somewhere in the middle. The economic fundamentals look powerful, especially overseas.

One irony is that, by holding government bond yields so low in recent years, risk-averse investors have made other assets look all the more enticing.

That could go on. If the demand for U.S. bonds from big investors such as China’s central bank remains reasonably strong, bond yields may not rise dramatically from current levels. That could underpin global economic growth and boost the appeal of taking greater risk in search of greater return.

(China, remember, has its own selfish reasons for buying U.S. bonds, particularly to support the dollar and keep American consumers buying Chinese goods.)

Boiled down, there are three potential scenarios for the world economy and central banks over the next year.

One is that the economy remains robust and the banks continue to tighten credit.

The second is that the economy slows modestly and the banks stop raising interest rates.

The third is that the economy slumps and the banks cut rates.

Of the three scenarios, the first two could be far better for more speculative investments than for government bonds.

Only the third scenario would seem to be a sure winner for government bonds and a sure loser for higher-risk assets.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit latimes.com/petruno.